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Posted by: Deepa Vasudevan on Wed, May 23rd, 2012

Accounting for the Rupee

Accounting for the Rupee

The rupee has depreciated steeply against the dollar. Newspapers often show a picture of the INR/USD exchange rate from August 2011 (45.3) to May 2012 (around 53-54) to highlight the 18% decline in that period. That is depressing enough. But if the exchange rate is viewed from the beginning of its managed float era, say, from March 1992, it becomes obvious what all the media fuss is about. The INR/USD exchange rate is at its lowest level ever (Pic 1 A and 1B).


Pic 1 A: INR/USD exchange rate based on RBI reference rate

INR/USD exchange rate based on RBI reference rate


Pic 1 B: Daily INR/USD rate from April 1, 2012 to May 21, 2012

Daily INR/USD rate from April 1, 2012 to May 21, 2012


Source: RBI, CCIL


The general view is that the high current account deficit- expected to be 4% of GDP in 2011-12 is responsible for this situation. This is the argument: India needs capital inflows to meet its current account deficit, but foreign inflows are declining. Domestic macro-policy issues and Euro area troubles suggest that the deficit will not improve in 2012-13. Anticipating that dollar inflows will remain poor in the near term, market forces have devalued the rupee against the dollar.


The exchange rate is determined largely by the demand for and supply of dollars at a point in time. From a current account point of view, exporters supply dollars and importers demand dollars. On the capital account, dollars flow in through FDI, FII inflows and foreign debt. The RBI is both the regulator and a participant. It can sell dollars to shore up supply; and it can buy dollars to mop up excess foreign exchange.


Dollar demand goes up for many reasons: a rise in crude prices, fall in INR/USD rate, or a sudden increase in gold investments by Indian savers. All of this happened to some extent in 2011-12. Dollar supply tightens when exports decline or foreign investment dries up. This also happened partly last year, though the full impact of the global slowdown on exports will show up in 2012-13. Logically, then, the rupee had to decline in 2011-12.


What about 2012-13? Various forecasts estimate the current account deficit at between 2.5-4 % of GDP. It may be less, if Europe and USA recover and exports pick up; or if crude prices decline significantly. It may be more, if crude or gold imports go up. A reasonable estimate of CAD is $80-100 billion. That means capital flows of about 1.5 -2 billion dollars per week are needed to finance the deficit*. Is that possible?  For that, let’s flip over to the capital account (Pic 2).


Pic 2: Capital Account of India’s Overall Balance of Payments


Capital Account of India’s Overall Balance of Payments

Source: RBI


The World Bank estimates net inward FDI to India at $28 bn in 2012-13**. In a good year, FII inflows tend to be around $30 bn; so total foreign investment flows are unlikely to be over $60 bn. Banking capital, which includes NRI deposit inflows, will probably be higher as NRI money flows in to take advantage of higher interest rates and favourable exchange rates. In 2011-12, NRIs remitted $11 bn into deposits, most of it in the last quarter***; one can reasonably assume that at least $10 billion will flow in this year.


The foreign debt component fluctuates depending on the interest differential between Indian and overseas lending rates. The 2012-13Union Budget encouraged ECBs by reducing withdrawing tax for infrastructure sector and allowing ECBs to part fund power projects.  But with industry slowing down, and domestic interest rates declining, demand for external loans may be subdued. Recent.


FCCB conversions have been hit by poor market conditions and rupee depreciation: any large FCCB defaults could raise the risk premium on corporate debt****. So let us assume that foreign loans bring in $15 billion.


That gives us a total inflow of $85 billion on the capital account, which neatly finances the estimated gap on the current account! Then why is the rupee falling? Because the market is not confident that capital inflows will actually be at this level.  FII inflows are volatile, and can turn negative at any point. NRI flows may dwindle if interest rates are reduced further. With the Euro crisis still continuing, risk averse investors may steeply increase dollar borrowing rates for Indian corporate.


The solution, therefore, is to work on investor confidence through actual policy. As many experts have been insisting in the press this past week: check demand for crude products by rationalizing prices, promote exports, focus on fast-tracking infrastructure projects. The recent sharp hike in petrol prices is a good starting point. By addressing the structural issues that have created a wide current account deficit in the first place, we will automatically attract inflows on the capital account. This is not wishful thinking; we saw it happen in 2004-07. It could be a reality again.


* See a neat discussion on current account financing needs by Haseeb Drabu here

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